U.S. Official Can't Deduct Losses from Sales of Properties Purchased Using Ill-Gotten Funds

(Parker Tax Publishing May 2022)

The Tax Court held that a taxpayer who, using his position as a U.S. consular official, took bribes in exchange for facilitating approvals of nonimmigrant visas and used the bribery proceeds to purchase real estate in Thailand which he later sold pursuant to a forfeiture agreement with the government, could not deduct his losses from the sales because that would undermine the public policy against bribery. The court also upheld a civil fraud penalty under Code Sec. 6663 against the taxpayer after finding that several badges of fraud were present in his bribery scheme. Sestak v. Comm'r, T.C. Memo. 2022-41.

Background

Michael Sestak was employed by the U.S. Department of State from 2003 until 2014. Between August 2010 and September 2012, Sestak worked as a consular officer at the U.S. Consulate in Ho Chi Minh City, Vietnam, and served as chief of the Consulate's Nonimmigrant Visa Unit. Sestak's responsibilities included reviewing U.S. visa applications, conducting interviews, and issuing U.S. visas to applicants.

In 2010, Sestak met a fellow U.S. citizen and resident of Vietnam named Binh Vo. Vo and Sestak devised a scheme whereby they would receive compensation in exchange for Sestak facilitating the approval of nonimmigrant visas to the United States through his position as a consular officer. This scheme required Sestak to use fake or code names, special email accounts, and cellphones for communicating with Vo. Vo would inform Sestak in advance of the identity of each foreign national who agreed to pay money in exchange for a U.S. visa, and Sestak would then attempt to personally handle the applicant's visa application, including conducting the applicant's interview. In several instances, Sestak issued visas to applicants who had been previously denied visas. From February to September 2012, Sestak approved 410 visa applications directed to him by Vo and others participating in the fraudulent scheme.

In an attempt to hide his bribery proceeds from the U.S. government, Sestak acquired real property in Thailand and, from June to December 2012, he purchased nine real estate properties for a total of approximately $3.2 million. On his 2012 federal income tax return, Sestak reported the wages he received as a State Department employee but did not report the bribery proceeds. The State Department eventually uncovered the fraudulent scheme. Sestak pleaded guilty to one count of conspiracy to commit offenses against the United States and to defraud the United States, one count of bribery of a public official, and one count of conspiracy to engage in a monetary transaction in property derived from specified unlawful activity.

Sestak entered into a written plea agreement with the United States, which included a consent order of forfeiture imposing a forfeiture money judgment in favor of the United States. Sestak agreed that his real estate holdings in Thailand represented bribery proceeds traceable to the fraudulent visa scheme and were subject to forfeiture. He agreed to cooperate and voluntarily sell his real estate holdings in Thailand and to transfer the net proceeds to the United States to satisfy a portion of the money judgment entered against him. Ultimately, Sestak sold his real estate holdings during 2013 to 2015, and in connection with these sales and other criminal forfeitures, the United States received approximately $1.5 million.

In 2015, the IRS audited Sestak's 2012 return and asserted a civil fraud penalty under Code Sec. 6663 against him. In the Tax Court, Sestak acknowledged receipt of the bribery proceeds during 2012. However, he argued that he should be allowed to claim a deduction equal to the difference between his acquisition costs for the Thailand properties and the amount realized on the liquidation of the properties. The IRS objected, arguing that allowing the deduction would be contrary to public policy.

Under Code Sec. 61, gross income from whatever source derived is subject to federal income taxation. In Traficant v. Comm'r, 89 T.C. 501 (1987), aff'd, 884 F.2d 258 (6th Cir. 1989), the Tax Court held that gross income specifically includes income from illegal sources, such as bribes. Code Sec. 63 provides that taxable income, however, means gross income minus those deductions allowed by law. Code Sec. 165(a) allows a deduction for any loss sustained during the tax year and not compensated for by insurance or otherwise. In the case of an individual, the deduction is limited under Code Sec. 165(c) to losses incurred in a trade or business or in any transaction entered into for profit, or to certain theft or casualty losses. Federal courts consistently have disallowed loss deductions where the deduction would frustrate a sharply defined federal or state policy. In Stephens v. Comm'r, 905 F.2d 667 (2d Cir. 1990), the Second Circuit held that the test of nondeductibility on public policy grounds under Code Sec. 165 is the severity and immediacy of the frustration of a "sharply defined national or state policy" that would result from allowance of the deduction.

Sestak argued that the liquidation of his real estate holdings in Thailand was not a forfeiture because the properties were located outside of the United States and, therefore, outside the jurisdiction of the U.S. court system. Sestak also contended that because the proceeds from the sales of his real estate holdings were voluntarily transferred at a loss to the United States as part of his plea agreement, he was entitled to deduct the loss from his bribery proceeds. Sestak relied on the Second Circuit's decision in Stephens where the taxpayer was convicted in a scheme to defraud a company of which he was a principal owner, and was ordered to make restitution to the company. The taxpayer later claimed a deduction for the restitution. The Tax Court denied the deduction, but the Second Circuit reversed, holding that the restitution payment was neither a fine nor a penalty paid to the government and thus the public policy exception did not preclude the deduction.

Sestak further contended that his payments to the United States were appropriately classified as compensatory and were, therefore, tax deductible. In addition, he asserted that he purchased the real estate holdings in Thailand for investment purposes, with the plan to rent the properties as an income-generating business. Thus, he argued, the liquidation of his real estate holdings resulted in a substantial deductible business loss. Sestak relied on the Supreme Court's decision in Lilly v. Comm'r, 343 U.S. 90 (1952), a case involving deductions claimed by opticians for payments they made to eye doctors for recommending certain opticians to their patients. The Supreme Court allowed the deduction after finding that the payments were at most professionally unethical but were not illegal or incidental to the violation of a law and therefore did not frustrate federal or state policy. Sestak also cited Comm'r v. Sullivan, 356 U.S. 27 (1958), where the Supreme Court allowed a deduction for expenses incurred in operating an illegal gambling enterprise, reasoning that to deny such deductions would result in taxing gross receipts rather than net income.

Analysis

The Tax Court held that Sestak was not entitled to deduct the difference between his acquisition costs (i.e., tax bases) in his Thailand properties and the amounts realized on the sale of the properties. The court found that to allow a deduction for losses arising out of forfeited proceeds obtained through illegal activities would undermine public policy by permitting a portion of the forfeiture to be borne by the government, thus taking the "sting" out of the forfeiture. The court found Sestak's reliance on Stephens to be misplaced, because Sestak did not pay any restitution; rather, the proceeds derived from his bribery scheme with Vo were subject to a court-ordered forfeiture. Thus, the court held that Sestak was not entitled to a loss deduction under Code Sec. 165 for the proceeds that he later forfeited pursuant to the forfeiture agreement with the United States.

The court rejected Sestak's argument that his case was different from other cases denying deductions for forfeitures because his plea agreement called for voluntary sales and forfeiture of funds. In the court's view, Sestak's proceeds were not akin to the payments in dispute in Lilly, since the amount Sestak forfeited were the essence of his illegal venture and the forfeiture was incidental to his violation of federal laws. The court further found that the rule articulated in Sullivan - that a taxpayer may be allowed to deduct legitimate (i.e., ordinary and necessary) business expenses in the operation of an illegitimate enterprise - was not determinative in this case because the forfeiture did not qualify as an ordinary and necessary business expense under Code Sec. 162. The court concluded that allowing a deduction in this case would undermine the impact of the sharply defined policy against bribery of a government official.

The court also upheld the imposition of the civil fraud penalty. In the court's view, the IRS successfully established five "badges of fraud" in Sestak's conduct: understating his income, concealing income or assets, engaging in illegal activities, dealing in cash, and filing false documents, including a false tax return. The court reasoned that Sestak held an influential position within the State Department which he illegally used for his personal gain and that his use of co-conspirators to transfer funds to foreign bank accounts and subsequent purchases of real estate holdings in Thailand reflected a sophisticated effort to conceal and otherwise prevent the collection of tax.

For a discussion of deducting ordinary and necessary business expenses, see Parker Tax ¶90,110. For a discussion of deducting losses under Code Sec. 165, see Parker Tax ¶84,300. For a discussion of the civil fraud penalty, see Parker Tax ¶262,125.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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